Chapter 2: Financial Markets and Institutions Learning Objectives 7 © 2015 Cengage Learning.. May not be copied, scanned, or duplicated, in whole or in part, except for use as Chapter 2
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© 2015 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as
Chapter 2 Financial Markets and Institutions
Learning Objectives
After reading this chapter, students should be able to:
Identify the different types of financial markets and financial institutions, and explain how these
markets and institutions enhance capital allocation
Explain how the stock market operates, and list the distinctions between the different types of stock markets
Explain how the stock market has performed in recent years
Discuss the importance of market efficiency, and explain why some markets are more efficient than others
Develop a simple understanding of behavioral finance
Trang 28 Lecture Suggestions Chapter 2: Financial Markets and Institutions
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Lecture Suggestions
Chapter 2 presents an overview of financial markets and institutions Students definitely have an interest in financial markets and institutions We base our lecture on the integrated case The case goes
systematically through the key points in the chapter, and within a context that helps students see the real world relevance of the material in the chapter We ask the students to read the chapter, and also to “look over” the case before class However, our class consists of about 1,000 students, many of whom view the lecture on TV, so we cannot count on them to prepare for class For this reason, we designed our lectures
to be useful to both prepared and unprepared students
Since we have easy access to computer projection equipment, we generally use the electronic slide show as the core of our lectures We make the electronic slides available to our students, and we strongly suggest to our students that they print a copy of the PowerPoint slides for the chapter and bring it to class This will provide them with a hard copy of our lecture, and they can take notes in the space provided Students can then concentrate on the lecture rather than on taking notes
We do not stick strictly to the slide show—we go to the board frequently to present somewhat different examples, to help answer questions, and the like We like the spontaneity and change of pace trips to the board provide, and, of course, use of the board provides needed flexibility Also, if we feel that
we have covered a topic adequately at the board, we then click quickly through one or more slides
The lecture notes we take to class consist of our own marked-up copy of the PowerPoint slides, with notes on the comments we want to say about each slide If we want to bring up some current event, provide an additional example, or the like, we use post-it notes attached at the proper spot The
advantages of this system are (1) that we have a carefully structured lecture that is easy for us to prepare (now that we have it done) and for students to follow, and (2) that both we and the students always know exactly where we are The students also appreciate the fact that our lectures are closely coordinated with both the text and our exams
The slides contain the essence of the solution to each part of the integrated case, but we also provide more in-depth solutions in this Instructor’s Manual It is not essential, but you might find it useful
to read through the detailed solution Also, we put a copy of the solution on reserve in the library for interested students, but most find that they do not need it Finally, we remind students again, at the start
of the lecture on Chapter 2, that they should bring a printout of the PowerPoint slides to class; otherwise, they will find it difficult to take notes
DAYS ON CHAPTER: 2 OF 56 DAYS (50-minute periods)
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Answers to End-of-Chapter Questions
2-1 The prices of goods and services must cover their costs Costs include labor, materials, and capital
Capital costs to a borrower include a return to the saver who supplied the capital, plus a mark-up (called a “spread”) for the financial intermediary that brings the saver and the borrower together The more efficient the financial system, the lower the costs of intermediation, the lower the costs to the borrower, and, hence, the lower the prices of goods and services to consumers
2-2 In a well-functioning economy, capital will flow efficiently from those who supply capital to those
who demand it This transfer of capital can take place in three different ways:
1 Direct transfers of money and securities occur when a business sells its stocks or bonds directly
to savers, without going through any type of financial institution The business delivers its securities to savers, who, in turn, give the firm the money it needs
2 Transfers may also go through an investment bank that underwrites the issue An underwriter serves as a middleman and facilitates the issuance of securities The company sells its stocks
or bonds to the investment bank, which then sells these same securities to savers The
businesses’ securities and the savers’ money merely “pass through” the investment bank
3 Transfers can also be made through a financial intermediary Here the intermediary obtains funds from savers in exchange for its own securities The intermediary uses this money to buy and hold businesses’ securities, while the savers hold the intermediary’s securities
Intermediaries literally create new forms of capital The existence of intermediaries greatly increases the efficiency of money and capital markets
2-3 A primary market is the market in which corporations raise capital by issuing new securities An
initial public offering (IPO) is a stock issue in which privately held firms go public Therefore, an IPO would be an example of a primary market transaction
2-4 A money market transaction occurs in the financial market in which funds are borrowed or loaned
for short periods (less than one year) A capital market transaction occurs in the financial market in which stocks and intermediate—or long-term debt (one year or longer)—are issued
a A U.S Treasury bill is an example of a money market security
b Long-term corporate bonds are examples of capital market securities
c Common stocks are examples of capital market securities
d Preferred stocks are examples of capital market securities
e Dealer commercial paper is an example of a money market security
2-5 If people lost faith in the safety of financial institutions, it would be difficult for firms to raise capital
Thus, capital investment would slow down, unemployment would rise, the output of goods and services would fall, and, in general, our standard of living would decline
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2-6 Financial markets have experienced many changes during the last two decades Technological
advances in computers and telecommunications, along with the globalization of banking and commerce, have led to deregulation, which has increased competition throughout the world As a result, there are more efficient, internationally linked markets, which are far more complex than what existed a few years ago While these developments have been largely positive, they have also created problems for policy makers With these concerns in mind, Congress and regulators have moved to reregulate parts of the financial sector following the recent financial crisis
Globalization has exposed the need for greater cooperation among regulators at the
international level Factors that complicate coordination include (1) the different structures in nations’ banking and securities industries; (2) the trend toward financial services conglomerates, which obscures developments in various market segments; and (3) the reluctance of individual countries to give up control over their national monetary policies Still, regulators are unanimous about the need to close the gaps in the supervision of worldwide markets
Another important trend in recent years has been the increased use of derivatives The market for derivatives has grown faster than any other market in recent years, providing investors with new opportunities but also exposing them to new risks Derivatives can be used either to reduce risks or to speculate Derivatives should allow companies to better manage risk but it’s not clear whether recent innovations have “increased or decreased the inherent stability of the financial system.”
2-7 The physical location exchanges are tangible entities Each of the larger ones occupies its own
building, allows a limited number of people to trade on its floor, and has an elected governing body A dealer market includes all facilities that are needed to conduct security transactions not conducted on the physical location exchanges The dealer market system consists of (1) the relatively few dealers who hold inventories of these securities and who are said to “make a market”
in these securities; (2) the thousands of brokers who act as agents in bringing the dealers together with investors; and (3) the computers, terminals, and electronic networks that provide a
communication link between dealers and brokers
2-8 The two leading stock markets today are the New York Stock Exchange (NYSE) and the Nasdaq
stock market The NYSE is a physical location exchange, while the Nasdaq is an electronic dealer-based market
2-9 There is an “efficiency continuum,” with the market for some companies’ stocks being highly
efficient and the market for other stocks being highly inefficient The key factor is the size of the company—the larger the firm, the more analysts tend to follow it and thus the faster new
information is likely to be reflected in the stock’s price Also, different companies communicate better with analysts and investors; and the better the communications, the more efficient the market for the stock
2-10 a False; derivatives can be used either to reduce risks or to speculate
b True; hedge funds have large minimum investments and are marketed to institutions and
individuals with high net worths Hedge funds take on risks that are considerably higher than that of an average individual stock or mutual fund
Highly Inefficient Highly Efficient
Small companies not followed by many analysts
Not much contact with
investors
Large companies followed
by many analysts Good communications with investors
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c False; hedge funds are largely unregulated because hedge funds target sophisticated investors
d True; the NYSE is a physical location exchange with a tangible physical location that conducts
auction markets in designated securities
e False; a larger bid-ask spread means the dealer will realize a higher profit
Trang 612 Integrated Case Chapter 2: Financial Markets and Institutions
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Integrated Case
2-1
Smyth Barry & Company
Financial Markets and Institutions
Assume that you recently graduated with a degree in finance and have just
reported to work as an investment adviser at the brokerage firm of Smyth Barry
& Co Your first assignment is to explain the nature of the U.S financial markets
to Michelle Varga, a professional tennis player who recently came to the United States from Mexico Varga is a highly ranked tennis player who expects to invest substantial amounts of money through Smyth Barry She is very bright;
therefore, she would like to understand in general terms what will happen to her money Your boss has developed the following questions that you must use to explain the U.S financial system to Varga
A What are the three primary ways in which capital is transferred
between savers and borrowers? Describe each one
Answer: [Show S2-1 through S2-3 here.] Transfers of capital can be made (1)
by direct transfer of money and securities, (2) through an investment bank, or (3) through a financial intermediary In a direct transfer, a business sells its stocks or bonds directly to investors (savers),
without going through any type of institution The business borrower receives dollars from the savers, and the savers receive securities (bonds or stock) in return
If the transfer is made through an investment bank, the investment bank serves as a middleman The business sells its
securities to the investment bank, which in turn sells them to the savers Although the securities are sold twice, the two sales
constitute one complete transaction in the primary market
Trang 7Chapter 2: Financial Markets and Institutions Integrated Case 13
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If the transfer is made through a financial intermediary, savers invest funds with the intermediary, which then issues its own
securities in exchange Banks are one type of intermediary, receiving dollars from many small savers and then lending these dollars to borrowers to purchase homes, automobiles, vacations, and so on, and also to businesses and government units The savers receive a
certificate of deposit or some other instrument in exchange for the funds deposited with the bank Mutual funds, insurance companies, and pension funds are other types of intermediaries
B What is a market? Differentiate between the following types of
markets: physical asset markets versus financial asset markets, spot markets versus futures markets, money markets versus capital
markets, primary markets versus secondary markets, and public
markets versus private markets
Answer: [Show S2-4 and S2-5 here.] A market is a venue where assets are
bought and sold There are many different types of financial markets, each one dealing with a different type of financial asset, serving a different set of customers, or operating in a different part of the
country Financial markets differ from physical asset markets in that real, or tangible, assets such as machinery, real estate, and
agricultural products are traded in the physical asset markets, but financial securities representing claims on assets are traded in the financial markets Spot markets are markets in which assets are bought or sold for “on-the-spot” delivery, while futures markets are markets in which participants agree today to buy or sell an asset at some future date
Money markets are the markets in which debt securities with maturities of less than one year are traded New York, London, and
Trang 814 Integrated Case Chapter 2: Financial Markets and Institutions
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Tokyo are major money market centers Longer-term securities,
including stocks and bonds, are traded in the capital markets The New York Stock Exchange is an example of a capital market, while the New York commercial paper and Treasury bill markets are money markets Primary markets are markets in which corporations raise capital
by issuing new securities, while secondary markets are markets in which securities and other financial assets are traded among investors after they have been issued by corporations Private markets, where transactions are worked out directly between two parties, are
differentiated from public markets, where standardized contracts are traded on organized exchanges
C Why are financial markets essential for a healthy economy and
economic growth?
Answer: [Show S2-6 here.] In a global context, economic development is
highly correlated with the level and efficiency of financial markets and institutions It is difficult, if not impossible, for an economy to reach its full potential if it doesn’t have access to a well-functioning financial system
A healthy economy is dependent on efficient funds transfers from people who are net savers to firms and individuals who need capital Without efficient transfers, the economy simply could not function Obviously, the level of employment and productivity, hence our
standard of living, would be much lower Therefore, it is absolutely essential that our financial markets function efficiently—not only quickly, but also at a low cost
D What are derivatives? How can derivatives be used to reduce risk?
Can derivatives be used to increase risk? Explain
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Answer: [Show S2-7 here.] Derivatives are any financial asset whose value is
derived from the value of some other “underlying” asset Derivatives can be used either to reduce risks or to speculate For an example of risk reduction, suppose an importer’s costs rise and its net income falls when the dollar falls relative to the yen The company could reduce its risk by purchasing derivatives whose values increase when the dollar declines This is a hedging operation, and its purpose is to reduce risk exposure Speculation, on the other hand, is done in the hope of high returns, but it raises risk exposure
E Briefly describe each of the following financial institutions:
investment banks, commercial banks, financial services corporations, pension funds, mutual funds, exchange traded funds, hedge funds, and private equity companies
Answer: [Show S2-8 here.] Investment banks are organizations that
underwrite and distribute new investment securities and help
businesses obtain financing
Commercial banks are the traditional department stores of finance serving a variety of savers and borrowers Historically, they were the major institutions that handled checking accounts and
through which the Federal Reserve System expanded or contracted the money supply Today, however, several other institutions also provide checking services and significantly influence the money
supply Conversely, commercial banks are providing an
ever-widening range of services, including stock brokerage services and insurance
Financial services corporations are large conglomerates that combine many different financial institutions within a single
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corporation Most financial services corporations started in one area but have now diversified to cover most of the financial spectrum Pension funds are retirement plans funded by corporations or government agencies for their workers and are administered primarily
by the trust departments of commercial banks or by life insurance companies Pension funds invest primarily in bonds, stocks,
mortgages, and real estate
Mutual funds are corporations that accept money from savers and then use these funds to buy stocks, long-term bonds, or short-term debt instruments issued by businesses or government units These organizations pool funds and thus reduce risks by
diversification
Exchange traded funds (ETFs) are similar to regular mutual funds and are often operated by mutual fund companies ETFs buy a
portfolio of stocks of a certain type—for example S&P 500—and then sell their own shares to the public
Hedge funds are similar to mutual funds because they accept money from savers and use the funds to buy various securities, but there are some important differences While mutual funds are
registered and regulated by the SEC, hedge funds are largely
unregulated This difference in regulation stems from the fact that mutual funds typically target small investors, whereas hedge funds typically have large minimum investments (often exceeding $1
million) that are marketed primarily to institutions and individuals with high net worths These funds received their name because they traditionally were used when an individual was trying to hedge risks Private equity companies are organizations that operate much like hedge funds, but rather than buying some of the stock of a firm,